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June 16, 2005
What's The Fed Up To?
If you are a reader of this weblog, I suspect that you have already taken a good look at the most recent edition of Econblog from the Wall Street Journal Online, wherein two of my favorite bloggers, Mark Thoma and Barry Ritholz share their praise (there, I think, in Mark's comments), criticisms (definitely there in Barry's comments), and advice for Alan Greenspan and company. The whole conversation is worthwhile, but what caught my attention (as a commentator) was this assertion from Mr. Ritholz: (in response to Dr. Thoma's support of formal inflation targeting):
Inflation targeting is a nice idea in theory, but in practice, the Fed has been much more active, undertaking a far broader set of policy initiatives. Indeed, many of the Fed's actions, as well as the policy pronouncements of its members, can be viewed as the central bank careening from one Fed-created problem ("mess" might not be too strong a word) to the next.
Maybe, just maybe, the behavior of the Federal Open Market Committee is a little less complicated than people make it out to be. In a post several months back, I noted this in discussing a speech by Ben Bernanke:
[Bernanke] suggests that monetary policy is more productively thought of as a framework that guides the central bank in its decision-making process, and offers two alternatives for consideration. The first:
Under a simple feedback policy, the central bank's policy instrument--the federal funds rate in the United States--is closely linked to the behavior of a relatively small number of macroeconomic variables, variables that either are directly observable (such as employment or inflation) or can be estimated from current information (such as the economy's full-employment level of output)...
A classic example of a simple feedback policy is the famous Taylor rule (Taylor, 1993). In its most basic version the Taylor rule is an equation that relates the current setting of the federal funds rate to two variables: the level of the output gap (the deviation of output from its full-employment level) and the difference between the inflation rate and the policy committee's preferred inflation rate.
OK, then, what would a Taylor-rule formulation, estimated to fit Greenspan-era federal funds rate choices, tell us about the recent behavior of the FOMC? Here's a picture:
A couple of interesting things emerge from this picture.
-- Given the path of inflation and GDP (relative to estimated potential), and the average response to those variables embodied in the Taylor rule, monetary policy does indeed appear to have been relatively tight in the period from late 1994 through 1995.
-- The extraordinary reductions in the federal funds rate target in 2001 just don't look that extraordinary (again, given the "output gap" and realized rates of inflation).
-- It appears that the Committee was doing exactly what it said it was doing in the period from mid-2003 through mid-2004: Maintaining a federal funds rate target that was lower than they might have normally chosen based on the economic statistics alone. Over that period, the funds rate target was lower than what one would predict on the basis of past FOMC behavior and the levels of GDP and inflation.
-- The 200 basis point increase in the federal funds rate target that commenced last summer appears to have put policy back on track with the Taylor rule.
More to follow...
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